Aug. 23 (Bloomberg) -- As markets convulsed in September
2008, Morgan Stanley Treasurer David Wong briefed the Federal
Reserve on a “dark” scenario in which the U.S. firm would need
at least $10 billion of emergency loans from the central bank.

It got 10 times darker by month’s end. Morgan Stanley
borrowed $107.3 billion, the most of any bank, according to data
compiled by Bloomberg News using information released in
response to Freedom of Information Act requests, related court
orders and an act of Congress.

Morgan Stanley’s borrowing -- more than twice the amount
all banks got from the Fed in the market squeeze that followed
the Sept. 11 terrorist attacks -- peaked after hedge funds
pulled $128.1 billion from the firm in two weeks, documents
released by the Financial Crisis Inquiry Commission show.

The first comprehensive examination of the Fed’s emergency
lending reveals how close the New York-based bank came to
running out of cash because of a run on its prime brokerage, the
unit that finances hedge funds’ trades and holds their cash and
securities. The Fed loans also show the degree to which Morgan
Stanley and other banks depended on such brokerage accounts for
funding, even though clients could close them on short notice.

“These were like hot-money deposits that could flee in an
instant,” said Tanya Azarchs, a former Standard & Poor’s
analyst who covered Morgan Stanley during the crisis and is now
a consultant in Briarcliff Manor, New York. The firm “never
thought that the hedge funds would get that spooked.”

29,346 Pages

Morgan Stanley’s Fed loans -- tallied in a Bloomberg News
database assembled from government records of more than 21,000
transactions and 29,346 pages -- open a window on Wall Street’s
secretive, lucrative and risky dealings with hedge funds.

The bank never told investors about the extent of its Fed
borrowings, even as they rose to the most in the 97-year history
of emergency lending by the U.S. central bank. Citigroup Inc.,
the New York-based lender whose balance sheet is more than twice
the size of Morgan Stanley’s, was the second-largest Fed
borrower, with a balance of $99.5 billion in January 2009.

At the peak of Morgan Stanley’s Fed borrowings, on Sept.
29, 2008, the firm reported that liquidity was “strong,”
without mentioning how dependent its cash stores had become on
the government lifeline. Liquidity refers to the daily funds a
bank needs to operate, including cash to cover withdrawals.

“It remains a black box,” said Adam Hurwich, a former
member of the Financial Accounting Standards Board’s Investors
Technical Advisory Committee who’s now a portfolio manager at
New York-based investment firm Ulysses Management LLC. “They
don’t give you the information to be able to decipher whether
they have changed anything.”

Prime brokers facilitate short trades, the sale of borrowed
stock in the hope of buying it back later at a lower price. They
also make margin loans to finance stock purchases. In exchange,
hedge funds usually keep their cash and stock in accounts at the
prime-brokerage companies.

Frozen Assets

Few analysts understood how dependent the brokerages had
become on such balances as a cheap source of funding, said Frank
Suozzo, a former head of growth financial-services research at
AllianceBernstein LP.

“Prime brokerage was presumed to be a pretty secure
business, where the funding was not actually part of the
liquidity of the bank,” said Suozzo, now president of advisory
firm FXS Capital LLC in Goldens Bridge, New York. “So if
clients pulled their money out, the view was that money had not
been lent out, so the cash would have been sitting there able to
hand over. It turns out that that was not entirely correct.”

In reality, “prime brokers were able to reuse clients’
assets to raise cash for their own activities,” the financial
crisis commission wrote in its final report, published in
January. Azarchs said that in her years covering Morgan Stanley
for S&P she never heard executives discuss the risk that the
funding might evaporate.

Lehman Brothers Holdings Inc.’s bankruptcy changed matters
when it froze at least $65 billion of assets held by that firm’s
London-based prime brokerage. For hedge funds, it was a lesson
not to bank with companies perceived to be at risk of failure,
according to the commission report. So hedge funds moved quickly
to pull their money from Morgan Stanley, viewed as the next
weakest securities firm after Lehman, according to the report.

Unregulated, Unrated

Mark Lake, a spokesman for Morgan Stanley, declined to
disclose the bank’s current hedge-fund balances.

“The financial crisis of 2008 caused the industry to
fundamentally re-evaluate the way it manages liquidity,” Lake
said. “We have taken the lessons we learned from that period
and applied them to our liquidity-management program to protect
both our franchise and our clients going forward.”

Lake wouldn’t say what practices the firm has changed.

Hedge funds are mostly private, unregulated and unrated
investment pools that often try to increase trading returns by
supplementing their own capital with stock and cash borrowed
from Wall Street’s prime-brokerage divisions.

Prime-Brokerage Revenue

The world’s 10 largest investment banks garnered about $10
billion in revenue from prime brokerage in 2010, almost as much
as they made trading stocks, according to London-based research
firm Coalition Development Ltd. The top 25 hedge-fund managers
earned $22.1 billion in 2010, according to AR magazine.

Prior to the crisis, prime brokerage was one of Morgan
Stanley’s most profitable businesses, generating at least $2
billion of revenue a year, according to Brad Hintz, a former
Morgan Stanley treasurer who now follows the firm as an analyst
at Sanford C. Bernstein & Co. in New York. The bank doesn’t
disclose how much revenue it gets from the business.

Any requirement that prime brokers keep more cash on hand
to survive a hedge-fund run may cut into the profitability of
the business. That’s because cash and Treasury securities that
can be liquidated easily in a squeeze are less profitable to
hold than loans and bonds that pay higher interest rates. Also,
prime brokers may have to issue more long-term debt, which would
force them to pay higher interest rates, said Richard Lindsey, a
former prime-brokerage chief at Bear Stearns Cos.

‘Infinitely Lived Borrowing’

“The safest way to fund something is to take out long-term
debt or, even better, equity, which is essentially infinitely
lived borrowing,” said Lindsey, now principal of Callcott Group
LLC in New York, which advises pension funds and endowments on
portfolio risks. “The problem of course is that those are the
most expensive forms of financing.”

In July 2008, Morgan Stanley said in a regulatory filing
that its policies were designed “to ensure adequate funding
over a wide range of market environments.” The firm’s
“contingency” plan anticipated a “potential, prolonged
liquidity contraction over a one-year time period,” according
to the filing. Resources included a $5 billion credit line from
a group of banks that could be used in an emergency.

At the end of August, Morgan Stanley had $179 billion of
liquidity, filings show. The firm had $2 billion of Fed loans
outstanding on Aug. 31, according to data compiled by Bloomberg.

As of Sept. 29, its liquidity had shrunk 44 percent to
$99.8 billion, according to internal reports released by the
crisis commission. By then, the firm had $107.3 billion of Fed
loans outstanding, the Bloomberg data show.

‘Adverse Funding Flows’

The bank didn’t mention the Fed loans in a press release
about its financial condition that day. Two weeks later, in
another filing, the firm disclosed it was benefiting from
“expanded sources of funding and liquidity resulting from the
Fed’s current policies,” without specifying the amount.

Staffers at the Federal Reserve Bank of New York were
astonished at how quickly Morgan Stanley’s cash dwindled, e-mails released by the crisis commission show.

At 11:05 p.m. on Sept. 15, 2008, William Brodows, a bank
supervision officer at the New York Fed, wrote to colleagues
that Wong, 44, the Morgan Stanley treasurer at the time, and two
other executives had called him at home that night. They wanted
“to express their concern that MS had experienced some adverse
funding flows late in the day from prime brokerage accounts,”
Brodows, 61, wrote.

Free Credit

Executives had already begun estimating Morgan Stanley’s
potential use of the Fed’s Primary Dealer Credit Facility, a
program created that year to supply emergency funds to
securities firms. Such companies lacked access to the central
bank’s discount window, its last-resort lending program.

“In their ‘dark’ scenario, they felt their PDCF usage
would increase to $10-$15 billion,” Brodows wrote in the e-mail.

At 6:59 a.m. the next morning, the concerns were echoed in
an e-mail by Matthew Eichner, 46, then an assistant director at
the Securities and Exchange Commission, to Brodows and other New
York Fed employees.

“Definitely some major outflows of PB balances at both GS
($5 b) and MS ($7 b),” Eichner wrote, referring to prime-brokerage balances at Goldman Sachs and Morgan Stanley. “Not
pretty.”

It got uglier. At 10:18 p.m. that night, a New York Fed
“on-site primary dealer update” stated that Morgan Stanley’s
prime brokerage had suffered “free credit withdrawals of $20
billion over the last two days, contributing to a $23 billion
decline in the parent company liquidity pool to $106 billion.”
Free credit is an industry term for hedge-fund cash balances,
according to Lindsey.

‘Catastrophic Scenario’

Two hours later, at 12:30 a.m. on Sept. 17, New York Fed
Senior Vice President Til Schuermann forwarded the update to
Brodows. Under Morgan Stanley’s “catastrophic scenario,”
Schuermann wrote, “they expect to lose $21.5 bn over the first
2 weeks -- not 2 days -- from PB!”

Jack Gutt, a spokesman for the New York Fed, declined to
comment. Eichner now works for the Fed in Washington.

Morgan Stanley’s shares fell 24 percent that day, and then-Chief Executive Officer John Mack sent a memo to the firm’s
46,000 employees saying “there is no rational basis for the
movements in our stock.”

“We’re in the midst of a market controlled by fear and
rumors, and short-sellers are driving our stock down,” Mack,
66, wrote, adding that “we have talked to” Henry Paulson, U.S.
Treasury secretary at the time, and then-SEC Chairman
Christopher Cox about the issue. He reiterated that the firm had
$179 billion of liquidity as of Aug. 31. He didn’t mention that
the figure had since dwindled to $117.7 billion, even as the
firm drew an additional $38.5 billion from the Fed.

Chanos Withdrawal

Jim Chanos, president and founder of New York-based hedge
fund Kynikos Associates LP, which specializes in short selling,
decided to pull $1 billion out of Morgan Stanley because he was
angry that Mack had put out a memo demonizing short sellers, a
person with knowledge of the matter said.

Chanos, 53, has since returned to Morgan Stanley as a
prime-brokerage client, partly because the firm in September
2009 announced that Mack would give up his daily operational
role as CEO, while remaining chairman, the person said.

On Sept. 19, 2008, Citigroup representatives told Fed
staffers that “Goldman and Credit Suisse are actively pursuing
Morgan’s prime business clients,” according to an internal
report that afternoon. The flows from Morgan Stanley and Goldman
Sachs were coming in so quickly that Citigroup barely had time
to vet the new clients, the report said.

Counterparty Risk

Within a week of Lehman’s bankruptcy, Morgan Stanley had
lost $84.8 billion of prime-brokerage free credits, according to
a Morgan Stanley treasurer’s report released by the crisis
commission. The next week, $43.3 billion more flowed out.

By Sept. 29, the bank was borrowing $61.3 billion from the
PDCF through units in the U.S. and London and getting $36
billion from the Term Securities Lending Facility. The TSLF
allowed broker-dealers to swap mortgage bonds for liquid
Treasuries that could then be sold or pledged for cash close to
their face value. Morgan Stanley also received $10 billion from
the Fed’s single-tranche open-market operations, another
emergency-lending program for broker-dealers.

The firm, which routinely demands collateral from hedge
funds to guard against default, faced a bigger risk when clients
suddenly began worrying the bank might not survive.

“This was a world turned on its head,” said Bernstein’s
Hintz. “Who would have guessed that hedge funds would have
worried about the counterparty risk of Morgan Stanley? Morgan
Stanley worried about the counterparty risks to hedge funds, not
the other way around.”

Mitsubishi Stake

The bank’s draws from the Fed began to ebb after Sept. 29,
2008, when the firm announced an agreement for Tokyo-based
Mitsubishi UFJ Financial Group Inc. to invest $9 billion in
Morgan Stanley for a 21 percent equity stake.

“This $9 billion investment will further bolster Morgan
Stanley’s strong capital and liquidity positions,” the firm
said in a press release that day.

Colm Kelleher, 54, Morgan Stanley’s chief financial officer
at the time, disclosed on Dec. 18, 2008, that the firm’s prime-brokerage balances had tumbled 46 percent to about $150 billion
as of Nov. 30 from $280 billion on Aug. 31. On a conference call
that day, Kelleher said the erosion was “clearly a function of
the downsizing of the hedge-fund business.”

‘Safer Place’

While many hedge funds have since returned to Morgan
Stanley, the firm doesn’t provide detailed updates on its prime-brokerage balances.

“Prime-brokerage revenues were up significantly” over the
previous quarter, while client balances “continued to grow
modestly,” Ruth Porat, 53, who replaced Kelleher as CFO, said
on a call with investors on July 21, without disclosing amounts.

Morgan Stanley’s liquidity stood at $182 billion as of June
30 and represents 22 percent of total assets, up from 18 percent
just before the crisis.

“Nobody could withstand a run on liquidity, except, of
course, the government,” Morgan Stanley CEO James Gorman, 53,
said in a May 24 speech in New York. “Hopefully we’re in a much
safer place as a result of it.”

In a brief interview afterward, Gorman declined to comment
on what changes the firm had made in its prime brokerage.

“We give out as much as we feel is appropriate on that
business,” he said.

A new rule adopted in December by the Basel Committee on
Banking Supervision, an international panel of regulators,
requires global banks to keep enough cash or cash-like reserves
on hand to survive a 25 percent run-off of balances in
“clearing, custody or cash-management” accounts during a
crisis lasting 30 days. The rule doesn’t take effect until 2015.

‘Almost Impossible’

“You don’t know whether the liquidity pool is required by
the ratings agencies, or whether it is required by the Federal
Reserve,” Hintz said. “I suspect there’s something of both.
But it’s a recognition that the old contingency funding plans
had a flaw, and that these events can happen very quickly.”

Hedge funds have changed their business practices to
protect themselves from the collapse of a prime broker, limiting
the amount of funding that securities firms can get from such
relationships, said Allan Yip, a former in-house prime-brokerage
lawyer for Bear Stearns.

Repledging Assets

Many funds now restrict the ability of securities firms to
repledge assets to obtain funding, a process known as
“rehypothecation,” Yip said. More funds stipulate that their
cash must be held in separate bank accounts.

“This has been a market-driven change, in terms of what
liquidity can be obtained by the banks,” said Yip, who now
advises hedge funds on prime-brokerage and trading documentation
as a partner in London at law firm Simmons & Simmons LLP.

Not that the funds have to worry. It’s probable the central
bank would again lend to a big firm such as Morgan Stanley if
another crisis hit, said Viral Acharya, a New York University
finance professor who serves as an academic adviser to the Fed,
according to the university’s website.

For hedge funds, “it’s basically like you get the too-big-to-fail benefit from being connected to a large financial
firm,” Acharya said. “If you dealt with a small prime broker,
say a boutique investment firm, it’s unlikely to be bailed
out.”